Should you pay off your mortgage, or invest?

With mortgage interest rates so low, some argue that there’s no point in paying off your mortgage early. Others argue that paying off debt is always a good idea and having less debt will always be a good thing. Here I examine both options, and aim to provide some clarity on the subject so that you can make a confident decision once and for all.

First of all, you’ll need to answer a few questions which will help you decide whether overpaying on your mortgage is a financial thumbs-up.

Do you have any other more expensive debts?

Expensive debts are those which cost a lot to pay off over time. Credit cards and store cards, for example, charge a high rate of interest over the course of a year. You should absolutely look to clear these debts as your main priority, as otherwise you’ll be locked in to paying interest to such companies which will only prolong your debt freedom.

Other examples might include unsecured bank loans, where the interest rate is significantly higher than the cost of your mortgage borrowing.

Always pay off more expensive debts before thinking about reducing your mortgage. Get rid of these debts and don’t allow them to pile back up again!

Are you already contributing to a pension scheme?

There are two main forms of pension scheme, either a workplace scheme where you contribute directly from your salary, or a private scheme where you make contributions as and when you wish, usually from your bank account.

Pensions are an excellent tax-efficient way to save, because either your employer or the government tops up your contributions with additional contributions and/or tax relief. Think about that for a second. Somebody else will add money to your pension on your behalf, no strings attached. In later articles, I will explain the exact calculations which are used behind the scenes in this process, and outline exactly how you claim this money. Trust me, it’s easy and well worth doing.

If you don’t have a pension and have money to spare, it’s important to think about paying in to one. The earlier you start, the sooner your retirement pot will start to grow.

Do you have sufficient emergency funds in place?

Elementary accounting judgement says it’s always worthwhile having a cash emergency fund. However, as outlined above it is still vital that all high-interest debts are cleared first, and not even the need for an emergency fund should outrank this.

High-interest credit/store cards and/or loans basically means that with each payment you make, the lender will keep a percentage for themselves. This is a HUGE red flag for us Money Marathoners, as rule number 1 says that we have to cut out paying interest to other companies. No exceptions.

So back to the task at hand. If you’ve 1) cleared your high-interest debts, and 2) are already contributing to a pension scheme, then it’s time to start your emergency fund. For more information on this, please see my earlier article.

If you don’t have any emergency funding set aside, then should any unexpected events rear their heads such as a leaking roof, then you will be forced to borrow. Thus, we start again at step 1 of this article and are forced to pay interest to a third-party. This will only prolong the achievement of debt freedom, and you may have guessed by now that this is inexcusable for Marathoners like us.

The basic rule to remember here is that any mortgage overpayments cannot be reclaimed. Once that payment is made, it is gone, so we must only do this when the 3 steps of this article have been satisfied.

Pay Off Mortgage Early – The Pros…

Save Money:The first and most obvious reason to pay off your mortgage early is it can save you tens of thousands of pounds in interest costs.

Peace of Mind: The second reason is peace of mind from owning your own home. It gives you a tremendous sense of both achievement and security to know that you have reached such a milestone. Not only will you never have to make a single further payment on your mortgage, but you will now have the security of knowing that barring a very unfortunate turn of events, you will never have nowhere to live.

Reduced Cost of Living: For most people, mortgage payments are the biggest monthly expense. Without a mortgage payment, you can save more, work less, or take that dream job you always wanted but couldn’t afford because of the lower salary.

Pay Off Mortgage Early – The Cons…

Reduced amount of “available cash”:This is the term that I give to money which you can quickly and easily put your hand on. A reduced level of available cash may be somewhat demoralising, and also may inhibit any future acquisitions.

Less diversification: Rich or poor, we all own a portfolio of some sorts. For some of us this may only consist of our workplace pension, for others it may consist of our home. For the lucky few among us it will be made up of both. The more money that we commit to our mortgage payment, then the more faith we are placing in that one asset, our home. Diversification is a topic that will be covered in later articles, and the importance of why we should diversify our assets will be explained in great detail. For now, think of it as putting all your eggs in one basket.

Not making the most of cheap money: As of this writing, the Bank of England base rate has just nudged up to 0.5%. This is still far below historic levels, and in fact only reverts back up to the Bank’s “emergency level” which was declared over a decade ago. In the meantime, rates have actually been cut to 0.25%, and if you were lucky enough to secure a fixed mortgage during this time like I was (August 2016 – October 2017) then I certainly salute you! So, with interest rates so low, it may be beneficially to not overpay, and put that money to better use elsewhere.

Final Thoughts

Once you’ve successfully completed the three steps outlined above, and you have managed to secure a low-cost mortgage, then it’s time to think long and hard about investing any additional money that you may have.

Notice how this question only becomes relevant after the prior issues are handled. The answer to the “pay off mortgage or invest” question is actually quite simple – whatever gives you the highest after-tax return on your money is the right decision.

Financial advisers will quickly point to research showing long-term historical returns for a low-cost index portfolio around 8%. So, if we compare this figure against the average 5-year fixed mortgage rate of 2.45% then it’s clear to see that not overpaying on the mortgage would be most beneficial.

Of course, investment returns are highly variable and so it is impossible to say whether the future performance of any portfolio will mimic the past. With that said, you would be hard pressed to find 20-30 year periods (the life of a typical mortgage) where an investment portfolio would not provide a higher return than recent mortgage interest rates.

While fiscal knowledge provides a relatively clear answer in that investing should provide the higher return over the long-term, this is really an emotional decision about your risk tolerance, confidence in the future, and belief in the science of investing. It’s why so many people prefer to get out of debt despite the compelling case against doing so.

As always, I’d love to hear your thoughts on this subject, and whether you have faced this dilemma in your own journey towards financial independence and/or home ownership.